Texas Denies COGS Deduction and Revenue Exclusion to Computer Software and Consulting Company
A Texas Comptroller’s Decision illustrates how companies must be careful not to underpay taxes when applying narrow definitions.
By Jess Johannesen, SALT manager
Aprio’s August 2016 SALT Newsletter included an article summarizing a Texas Tax Policy Division letter ruling that communicated two revised Franchise Tax policies. The first concerned an exclusion from total revenue of certain flow-through funds mandated by contract (or subcontract) to be distributed to other entities, and the second concerned qualifying activities for the cost of goods sold (COGS) deduction. Subsequently, Texas released a Comptroller’s Decision in October 2016 which addresses a taxpayer’s application of these Franchise Tax policies, including a COGS deduction associated with the production of computer software as well as an exclusion from revenue for payments made to its independent contractors.  In this recent case, the Administrative Law Judge (“ALJ”) determined that the taxpayer was not entitled to the COGS deduction nor the revenue exclusion at issue.
The taxpayer was a software products and consulting services company. The taxpayer would hire employees and contract with independent contractors that would provide the computer consulting and programming services. The subcontracting agreement noted that any work performed by the independent contractor was the property of the taxpayer or its customer. Additionally, the taxpayer would enter into agreements with its customers to perform services and provide deliverables. These customer agreements provided that all work product and deliverables created for or provided to the customer were owned exclusively by such customer.
Under audit, the taxpayer asserted that the amounts it pays employees and independent contractors to build and design computer software for its customers were allowable COGS deductions. Texas laws state that computer programs are included in the term “tangible personal property,” for purposes of the COGS deduction.  However, the taxpayer may only claim a COGS deduction if it owns the goods that are being sold in the ordinary course of business.  The ALJ found that the taxpayer’s agreements with the independent contractors and the taxpayer’s customers collectively indicate that the taxpayer does not own the deliverables (e.g., software) that it was providing to its customers. Therefore, the ALJ concluded that the taxpayer was not entitled to claim a COGS deduction for the employee and independent contractor costs associated with the development of the computer software since the taxpayer did not own the deliverables provided to its customers.
The second issue under audit was the taxpayer’s exclusion from total revenue of the payments to independent contractors for the “construction, improvement, and repair of software.” Under Texas law, there are three categories of excludable flow-through funds that are mandated by contract to be distributed to other entities: (1) sales commissions to nonemployees, (2) the tax basis of securities underwritten and (3) subcontracting payments related to the provision of services, labor, or materials in connection with certain real property contract activities.  The ALJ noted that these stated exclusions do not include a payment made under an ordinary contract for the provision of services in the regular course of business. While the taxpayer contended that its payments were excludable under the third prong, it is clear that the payments were not related to qualifying real property activities since the independent contractors were consultants developing computing programs (i.e., tangible personal property as noted above). Accordingly, the ALJ concluded that the taxpayer was not entitled to the revenue exclusion for the taxpayer’s payments to its independent contractors.
This case illustrates a situation where a taxpayer incorrectly applied these narrow definitions to its business operations. The key factor for the COGS deduction requires that the taxpayer legally own the goods that it sells in its ordinary course of business, while the revenue exclusion at issue only applies to certain defined business activities. While these rules specifically apply to the Texas Franchise Tax statutes, this case provides a valuable lesson that can be applied beyond Texas. State income tax and franchise tax rules and definitions vary from state to state. In order to maximize exclusions and deductions while avoiding underpaying the tax owed, businesses must understand fully how to apply the rules to their specific operations to determine which exclusions and deductions they are entitled to claim.
Aprio’s SALT group has experience working with companies to carefully analyze and apply the appropriate exclusions/deductions so that each business minimizes the amount of state tax owed and, at the same time, minimizes risk by not overstating or claiming amounts to which the business is not entitled. We constantly monitor these and other important state tax issues, and we will include any significant developments in future issues of the Aprio SALT Newsletter.
This article was featured in the January 2017 SALT Newsletter. To view the entire newsletter, click here.
 Texas Comptroller’s Decision 201609097H, 10/10/2016.
 Tex. Tax Code Ann. §171.1012(a)(3).
 Tex. Tax Code Ann. §171.1012(a), (i).
 Tex. Tax Code Ann. §171.1011(g).
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